Why most fund managers can’t beat the market — and what that means for you

This post is drawn from The Street-Smart Trader by Ian Lyall. Republished with permission.

There is a question that sits at the heart of every investment decision a private investor makes, even if they never consciously frame it that way. Is the person managing my money actually any good?

The uncomfortable answer, supported by decades of data, is that most of the time they are not. Not incompetent, necessarily. Not dishonest. But not good enough to justify the fees they charge or the confidence with which they sell their services. The evidence on active fund management is one of the most consistently lopsided stories in all of finance, and yet it remains largely invisible to most retail investors because the industry has every incentive to keep it that way.

The numbers are not obscure or contested. S&P Global publishes the SPIVA (S&P Indices Versus Active) scorecard twice a year, comparing active fund performance against their relevant benchmark indices across every major market. The UK results are bleak for anyone selling active management as a proposition. Year after year, the scorecard shows that around 80 per cent of active UK equity funds fail to beat the FTSE All Share over a ten-year period, once fees are accounted for. The figure fluctuates slightly depending on the vintage and the market cycle, but the direction of travel never changes. Over long time horizons, active managers lose to the index the overwhelming majority of the time.

Ian Lyall documented the shape of this problem in The Street-Smart Trader when the data was already well-established, and his framing holds up just as well today. The basic logic has not changed. Every time an active fund manager buys or sells a share, there is a cost. Brokerage commissions, bid-ask spreads, the market impact of moving a large position, and the annual management charge that sits on top of everything else. These costs are a constant drag on returns. The index, by contrast, incurs almost none of them. It simply sits there, reflecting the performance of the market in aggregate. For the active manager to justify their existence, they need to outperform the index by enough to cover all of those costs and then some. Very few can do it consistently.

What makes this striking is not just that underperformance exists, but that it compounds over time. A fund that charges 1.5 per cent per year in total costs, which is not unusual for an actively managed UK equity fund, will consume a significant proportion of a long-term investor’s wealth through the power of compounding alone. A private investor who started with £50,000 and left it in such a fund for 25 years, assuming it exactly matched market returns before costs, would end up meaningfully poorer than if they had simply bought a low-cost index tracker from day one.

So why does active management survive, let alone thrive? The industry manages hundreds of billions of pounds in the UK alone, and millions of investors continue to hand money to fund managers despite the evidence. The answer lies in a combination of psychology, incentives, and market structure that Lyall understood well from his years reporting on the City.

Career risk is one of the most powerful forces operating inside any asset management firm. A fund manager who deviates radically from the benchmark and gets it wrong faces serious professional consequences. One who underperforms slightly, but does so in a way that can be explained with reference to sector rotation or macro headwinds, keeps their job. The rational response to this incentive structure is to run a portfolio that hugs the benchmark closely enough to avoid catastrophic relative performance, while charging fees that only a truly differentiated strategy could justify. Critics call this closet indexing. It is legal. It is widespread.

Fee structures compound the problem. Asset management firms generate more revenue from managing larger pots of money, so there is a powerful organisational incentive to gather assets rather than deliver performance. A firm that launches a fund with a strong track record attracts money. When the performance fades, as it almost always does, some investors leave, but the base rarely disappears entirely. Marketing budgets remain large. The funds persist long after the edge has gone.

The Retail Distribution Review, which the FCA introduced in 2013, was supposed to shift some of this. By banning the commission payments that had historically rewarded financial advisers for recommending high-cost active funds, the FCA removed one of the most structurally distorting incentives in the market. In the years since RDR, the flow of money into passive funds has accelerated sharply. Vanguard, BlackRock, and the other large index providers have gathered enormous sums from UK investors who either worked out the arithmetic themselves or took advice from a fee-based adviser with no incentive to push expensive products. But the shift has been slower and less complete than the data would suggest it should be.

Part of the reason is that active managers are skilled communicators. They produce quarterly commentary explaining why their underperformance is temporary, why conditions in their area of expertise are about to change, why the market is finally going to reward patient, contrarian positioning. Some of this is written in good faith. Some of it is not. Either way, it keeps investors sitting in funds they might otherwise leave.

None of this means that every active fund is a bad idea or that outperformance is impossible. Some managers do beat their benchmarks consistently over long periods. A small number appear to have genuine skill rather than luck. The problem is identifying them in advance. The evidence on performance persistence is almost as bleak as the evidence on outperformance itself. Last year’s top quartile fund manager is only modestly more likely than chance to be next year’s top quartile fund manager.

For a private investor trying to make sense of all this, the practical implication is fairly simple. Before paying for any form of active management, ask whether the track record is long enough to distinguish skill from luck, whether the costs are genuinely justified by the strategy’s differentiation, and whether the person selling the product has any financial interest in you buying it. Those three questions will not identify every bad fund, but they will cut out a significant proportion of the damage.

The index is not exciting. It does not come with a quarterly letter or a fund manager who knows the story behind every position. It just delivers what the market delivers, year after year, at minimal cost. For most private investors, most of the time, that is considerably more than they are getting from the alternative.

Street Smart is a series drawn from first-hand experience of the City of London, updated as each new chapter arrives.

Disclaimer: The value of investments can go down as well as up, and you may get back less than you invest. This article is for informational and educational purposes only and does not constitute financial advice. Always do your own research and consider seeking independent advice before making any investment decision.